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Can We Expect An Oil Price Correction Soon?

Oil prices touched a more than two-and-a-half-year high this week, but have faltered mid-week. Market sentiment is more bullish than it has been in a long time, but the risk of falling back is still very much alive.

There has been a series of market forces that have come together, all at just the right time, to push Brent up into the mid-$60s per barrel. Falling inventories, near-unanimity from OPEC to extend the production cuts, a slowdown in U.S. shale, bullish positioning from oil traders and some unexpected unrest in the Middle East. Taken together, these factors caused Brent to gain $10 per barrel in the past month.

But as has happened in the past, oil price rallies can quickly reverse if sentiment shifts. That tends to occur when the gains look to have gone too far. And there are some reasons to believe that oil is overpriced at this point, at least according to some trading theories. Bloomberg reports that the 14-day relative strength index for WTI rose to 70 on Tuesday, which suggests that the oil benchmark is overbought. Francisco Blanch, head of commodities research at Bank of America Merrill Lynch, said the top for oil prices could be near, although he said there is some leeway on the upside by about $4 or $5 per barrel.

If the upper limit has arrived, then hedge funds and other money managers could quickly liquidate their long bets, sparking a sudden price correction. Because the current positioning is overwhelmingly bullish, there is probably not a lot of room left on the upside. If the herd exits all at once, prices could quickly slide. Bloomberg also cited the exodus of capital from an ETF that tracks oil prices as evidence that sentiment is starting to shift. “You have to treat it like a hot potato, to avoid getting your returns corroded by the roll,” Eric Balchunas, an ETF analyst for Bloomberg Intelligence. “The longer you stay there, the longer you could get hurt.”

The comeback of U.S. shale is obviously another worry, particularly with oil prices up as high as they are. Shale drillers could also step up their hedging with WTI safely above $50 per barrel, locking on some future production. The most recent data from the EIA should raise some concerns for oil bulls. The agency estimated that U.S. oil production jumped by a sizable 67,000 bpd in the first week of November to 9.620 million barrels per day (mb/d). Meanwhile, crude inventories unexpectedly rose by 2.1 million barrels, halting the steady declines in stocks over the past two months.

“The most notable thing in the EIA report was that production increased. We’re on our way to set record crude oil production in 2018,” Andrew Lipow, president of Lipow Oil Associates in Houston, told Reuters in an interview. Meanwhile, China’s oil imports fell to just 7.3 million barrels per day in October, a sharp decline from 9 mb/d a month earlier.

However, the flip side to this argument is that the shale industry has been running out of steam. The rig count has consistently fallen since August, even with oil prices edging up. Because the effect on actual oil production from changes in the rig count takes several months to materialize, the three-month decline in the rig count since August likely portends production stagnation in the months ahead. Related: Does The U.S. Lead The World In Carbon Emissions Reduction?

The shale industry might spring into action with the recent jump by WTI in the mid- to upper-$50s, but it will take quite a bit of time before that translates into production gains.

Moreover, the EIA might be overestimating how much oil the shale industry is producing. As monthly figures come in on a lag, they are revealing that the U.S. produced a lot less oil in the second and third quarter than we thought at the time.

Finally, geopolitics could still surprise. Venezuela stands out as a place where a major unexpected supply outage could occur. Some see the South American nation losing 600,000 bpd in 2018. If that were to occur, it’s hard to imagine oil prices not going much higher.